MANAGEMENT ACCOUNTING - Solutions Manual
CHAPTER 20 CAPITAL CAPITAL BUDGETING DECISIONS
I.
Questions
1. A capital capital invest investme ment nt invol involves ves a current commit commitme ment nt of funds with with the expecta expectatio tion n of generat generating ing a satisfacto satisfactory ry return return on these these funds over over a relatively extended period of time in the future. 2. Cost Cost of capital capital is the the weig weight hted ed mini minimu mum m desire desired d average average rate that a company must pay for long-term capital while discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. . !he basic basic princ principl iples es in in capital capital budgeti budgeting ng are" 1. Capital investm investment ent models models are focused focused on the future future cash inflow inflowss and outflows - rather than on net income. 2. Inve Invest stm ment ent prop propos osal alss shou should ld be eval evalua uate ted d acco accord rdin ing g to thei their r differential effects on the company#s cash flows as a whole. . $ina $inanc ncin ing g cost costss asso associ ciat ated ed with ith the the proj projec ectt are are excl exclud uded ed in the the analysis of incremental cash flows in order to avoid the %doublecounting& of the cost of money. '. !he conc concep eptt of the time time value value of mone money y recogn recogni( i(es es that that a peso peso of present return return is worth more more than a peso of future return. ). Choose Choose the investme investments nts that will will maximi(e maximi(e the total total net present value of the projects subject to the capital availability constraint. '. !he major major classi classifica ficatio tions ns as as to purpose purpose are" are" 1. *epl *eplac acem emen entt proje project ctss - thos thosee invo invollving repl replac aceements nts of worn worn--out out asse assets ts to avoi avoid d disruption of normal operations+ or to improve efficiency. 2. ,roduc ,roductt or proc process ess impro improve vem ment ent - projects projects that that aim to produc producee additi additiona onall revenu revenuee or to reali(e reali(e cost savings. . xpansion - projects projects that enha enhance nce longlong-term term returns returns due due to increase increased d profitab profitable le volume. ). reate reaterr amou amounts nts of capita capitall may may be used in project projectss whos whosee combi combine ned d returns will exceed any alternate combination of total investment. 20-1
Chapter 20 Capital Budgeting Decisions
/. 0o. !his implies that any euity funds are cost free and this is a dangerous position because it ignores the opportunity cost or alternative earnings that could be had from the fund. . 3es+ if there are alternative earnings foregone by stoc4holders. 5. Capital budgeting screening decisions concern whether a proposed investment project passes a preset hurdle+ such as a 1)6 rate of return. Capital budgeting preference decisions are concerned with choosing from among two or more alternative investment projects+ each of which has passed the hurdle. 7. !he %time value of money& refers to the fact that a peso received today is more valuable than a peso received in the future. A peso received today can be invested to yield more than a peso in the future. 18. 9iscounting is the process of computing the present value of a future cash flow. 9iscounting gives recognition to the time value of money and ma4es it possible to meaningfully add together cash flows that occur at different times. 11. Accounting net income is based on accruals rather than on cash flows. :oth the net present value and internal rate of return methods focus on cash flows. 12. ;ne simplifying assumption is that all cash flows occur at the end of a period. Another is that all cash flows generated by an investment project are immediately reinvested at a rate of return eual to the discount rate. 1. 0o. !he cost of capital is not simply the interest paid on long-term debt. !he cost of capital is a weighted average of the individual costs of all sources of financing+ both debt and euity. 1'. !he internal rate of return is the rate of return on an investment project over its life. It is computed by finding that discount rate that results in a (ero net present value for the project. 1). !he project profitability index is computed by dividing the net present value of the cash flows from an investment project by the investment reuired. !he index measures the profit
nder both methods+ a peso received in the future is weighed the same as a peso received today. $urthermore+ the 20-2
Capital Budgeting Decisions Chapter 20
paybac4 method ignores all cash flows that occur after the initial investment has been recovered. II. Matching Type 1. 2. . '. ).
A C $ : I
/. . 5. 7. 18.
? 9 @
III. Exercises Exercise 1 (Siple !ate o" !eturn Metho#$
!he annual incremental net operating income is determined by comparing the operating cost of the old machine to the operating cost of the new machine and the depreciation that would be ta4en on the new machine" ;perating cost of old machine...................................................... ess operating cost of new machine............................................. ess annual depreciation on the new machine <,58+888 B 18 years=.................................................................................. Annual incremental net operating income.....................................
5+888 ,1)+888
Cost of the new machine.............................................................. ess scrap value of old machine................................................... Initial investment..........................................................................
,58+888 )+888 ,)+888
Eimple rate of return
D
,+888 18+888
Annual incremental net operating income Initial investment
,1)+888 D D 286 ,)+888 Exercise 2 (%asic &resent 'alue Concepts$ 1. a. ,'88+888 8.7' D ,1+/88. b. ,'88+888 8.12 D ,25'+588. 2. a. ,)+888 '.)) D ,21+). b. ,)+888 ./5) D ,15+'2). . !he factor for 186 for 28 years is 5.)1'. !hus+ the 20-
present
value
of
Chapter 20 Capital Budgeting Decisions
!om#s winnings would be" ,)8+888 5.)1' D ,'2)+88. Fhether or not !om really won a million pesos depends on your point of view. Ehe will receive a million pesos over the next 28 yearsG however+ in terms of its value right now she won much less than a million pesos as shown by the present value computation above. Exercise (A"ter-Tax Costs$
a.
Hanagement consulting fee.............................. Hultiply by 1 8.8........................................ After-tax cost...................................................
,188+888 8.8 , 8+888
b.
Increased revenues........................................... Hultiply by 1 8.8........................................ After-tax cash flow
,'8+888 8.8 ,25+888
c.
!he depreciation deduction is ,218+888 B years D ,8+888 per year+ which has the effect of reducing taxes by 86 of that amount+ or ,7+888 per year.
Exercise ) (%asic Net &resent 'alue Anal*sis$
Amount of 12% Present Value Year(s) Cash Flows Factor of Cash Flows ,urchase of the stoc4..................... 0ow ,<15+888= 1.888 ,<15+888= Annual dividendsJ......................... 1-' ,28 .8 2+15 Eale of the stoc4............................ ' ,22+)88 8.// 1'+18 0et present value........................... ,< 1+)8= J788 shares ,8.58 per share per year D ,28 per year. 0o+ Hs. Cru( did not earn a 126 return on the share. !he negative net present value indicates that the rate of return on the investment is less than the discount rate of 126. Exercise + (Internal !ate o" !eturn an# Net &resent 'alue$
1.
$actor of the internal D rate of return D
*euired investment Annual cash inflow ,1/+88 ,2)+888 20-)
D
).'/5
Capital Budgeting Decisions Chapter 20
A factor of ).'/5 represents an internal rate of return of 1/6. 2. Item Year(s) Initial investment........................... 0ow 0et annual cash inflows....... ......... 1-1' 0et present value...........................
Amount of 16% Present Value Cash Flows Factor of Cash Flows ,<1/+88= 1.888 ,<1/+88= ,2)+888 ).'/5 1/+88 , 8
!he reason for the (ero net present value is that 1/6
*euired investment Annual cash inflow
,1/+88 !he /.5) factor is closest to /.752+ the factor for the 116 rate of return. D D /.5) !hus+ to the nearest whole percent+ the,28+888 internal rate of return is 116.
Exercise , (%asic Net &resent 'alue an# Internal !ate o" !eturn Anal*sis$
1. Item Year(s) Initial investment..................... 0ow Annual cash inflows................ 1-' 0et present value....................
Amount of 15% Present Value of Cash Flows Factor Cash Flows ,<'8+)8= 1.888 ,<'8+)8= ,1)+888 2.5)) '2+52) , 2+')
3es+ this is an acceptable investment. Its net present value is positive+ which indicates that its rate of return exceeds the minimum 1)6 rate of return reuired by the company. 2.
$actor of the internal D rate of return D
Investment reuired 0et annual cash inflow ,111+)88 ,28+888 20-+
D
).))
Chapter 20 Capital Budgeting Decisions
A factor of ).)) represents an internal rate of return of 1/6. .
$actor of the internal D rate of return
Investment reuired 0et annual cash inflow
,1'+12) A factor of )./)8 represents internal rate Dof )./)8 return of 126. !he D an ,2+)88 company did not ma4e a wise investment because the return promised by the machine is less than the reuired rate of return.
20-,
Capital Budgeting Decisions Chapter 20
IK. Problems &role 1 (E.uipent !eplaceent Sensiti/it* Anal*sis$
e!uirement 1 "otal Present Value A.
:.
0ew Eituation" *ecurring cash operating costs <,2/+)88 x 2./7= Cost of new euipment 9isposal value of old euipment now ,resent value of net cash outflows ,resent Eituation" *ecurring cash operating costs <,')+888 x 2./7= 9isposal value of old euipment four years hence <,2+/88 x 8.)1/= ,resent value of net cash inflows 9ifference in favor of replacement
, 1+25) ''+888 <)+888= ,118+25) ,121+8)8 <1+'2= ,117+85 , 7+'2
e!uirement 2 ,aybac4 period for the new euipment
D
,''+888 ,)+888 ,15+)88
D
2.1 years
e!uirement # et L D annual cash savings et ; D net present value L <2./7= M ,)+888 - ,''+888 - ,1+'2 D ; 2./7L D ,'8+'2 L D ,1'+77 If the annual cash savings decrease from ,15+5)8 to ,1'+77 or by ,+)8+ the point of indifference will be reached. Another alternative way to get the same answer would be to divide the net present value of ,7+'2 by 2./78. &role 2
Annual cash expenses of the manual boo44eeping 20-
Chapter 20 Capital Budgeting Decisions
machine system+ ,7+588 x 12 Annual cash expenses of computeri(ed data processing Annual cash savings before taxes Year 1 ,/'+888 28+888 ,''+888 22+888 ,'2+888
Year 2 ,/'+888 1/+888 ,'5+888 2'+888 ,'8+888
Year # ,/'+888 12+588 ,)1+288 2)+/88 ,5+'88
After "a& Cash Inflows ,'2+888 '8+888 5+'88 28+888 1)+/88J
PV Factor x 8.787 x 8.52/ x 8.)8 x 8.)8 x 8.)8
PV , 5+15 +8'8 25+588 1)+888 11+88 ,12/+15 188+888 , 2/+15
Annual cash savings
3ear 1 3ear 2 3ear 3ear Ealvage 3ear !ax loss Investment
,11+/88 )+/88 , /'+888
!he ,1)+/88 tax benefit of the loss on the disposal of the computer at the end of year is computed as follows" stimated salvage value stimated boo4 value" ?istorical cost Accumulated depreciation stimated loss !ax rate !ax effect of estimated loss
, 28+888 ,188+888 '5+588
)1+288 ,<1+288= )86 ,<1)+/88=
Eince the net present value is positive+ the computer should be purchased replacing the manual boo44eeping system.
&role
e!uirement 1
,<88+888=
Capital Budgeting Decisions Chapter 20
Eelling price :oo4 value oss on disposal !ax rate !ax benefit of loss on disposal *euired investment
,
8 /8+888 ,/8+888 8.'
sing new euipment O15+888 <,28 - ,=P J >sing existing euipment O11+888 <,28 - ,7=P Increased cash flows ess" !axes <8.'8 x ,11+888= Increased cash flows after taxes 9epreciation tax shield" 9epreciation on new euipment <,88+888 ÷ )= ,/8+888 9epreciation on existing euipment <,/8+888 ÷ )= 12+888 Increased depreciation charge ,'5+888 !ax rate 8.'8 9epreciation tax shield *ecurring annual cash flows NNNNNNNNNNNNNNNNN J
2'+888 ,<2/+888=
,2'+888 121+888 11+888 ')+288 , /+588
17+288 , 5+888
!he new euipment is capable of producing 28+888 units+ but !C ,roducts can sell only 15+888 units annually. !he sales manager made several errors in his calculations of reuired investment and annual cash flows. !he errors are as follows" e!uire' inestment !he cost of the mar4et research study <,''+888= is a sun4 cost because it was incurred last year and will not change regardless of whether the investment is made or not. !he loss on the disposal of the existing euipment does not result in an actual cash cost as shown by the sales manager. !he loss on disposal results in a reduction of taxes+ which reduces the cost of the new euipment. Annual cash flows !he sales manager considered only the depreciation on the new euipment rather than just the additional depreciation which would result from the acuisition of the new euipment. !he sales manager also failed to consider that the depreciation is a noncash expenditure which provides a tax shield.
20-
Chapter 20 Capital Budgeting Decisions
-
!he sales manager#s use of the discount rate
e!uirement 2 ,resent value of future cash flows <,5+888 x ./= *euired investment
,272+28 2/+888 , 1/+28
&role )
e!uirement 1 ,<)8+888= e!uirement 2 ,<'//+288= e!uirement # ,<2+'88= &role +
1. !he net annual cost savings is computed as follows" *eduction in labor costs........................................................................ ,2'8+888 *eduction in material costs.................................................................... 7/+888 !otal cost reductions.............................................................................. /+888 ess increased maintenance costs <,'+2)8 12=................................... )1+888 0et annual cost savings......................................................................... ,25)+888
2. >sing this cost savings figure+ and other data provided in the text+ the net present value analysis is" Year(s) Cost of the machine..................................... 0ow Installation and software.............................. 0ow Ealvage of the old machine.......................... 0ow Annual cost savings..................................... 1-18 ;verhaul reuired........................................ / Ealvage of the new machine........................ 18 0et present value.........................................
20-10
Amount of 1*% Cash Flows Factor ,<788+888= 1.888 ,
Present Value of Cash Flows , <788+888=
Capital Budgeting Decisions Chapter 20
0o+ the etching machine should not be purchased. It has a negative net present value at an 156 discount rate. . !he intangible benefits would have to be worth at least ,'2+51 per year as shown below" *euired increase in net present value $actor for 18 years
D
,172+'88 D '.'7'
,'2+51
!hus+ the new etching machine should be purchased if management believes that the intangible benefits are worth at least ,'2+51 per year to the company. &role , (2) Tax Effect
(1) Items and Computations Year(s) Amount Investment in new trucks.......................................... Now P(450,000) Salvage from sale of the ol trucks.......................... Now P!0,000 1 " 0.!0 Net annual cash recei$ts.......................................... 1%& P10&,000 1 " 0.!0 *e$reciation euctions+.......................................... 1%& P5,#50 0.!0 verhaul of motors................................................... 5 P(45,000) 1 " 0.!0 Salvage from the new trucks.................................... & P#0,000 1 " 0.!0 Net $resent value.....................................................
(1) × (2) After-Tax Cash Flos P(450,000) P#1,000 P'5,00 P1,&'5 P(!1,500) P14,000
12! Factor 1.000 1.000 4.& 4.& 0.5' 0.404
"resent #alue of Cash Flos P(450,000) #1,000 !'5,5&1 &!,&!5 (1',&1) 5,5 P 1&,#11
J ,')8+888 B 5 years D ,)/+2)8 per year
Eince the project has a positive net present value+ the contract should be accepted. &role 1.
$actor of the internal D rate of return
*euired investment Annual cash inflow ,1'2+7)8 ,+)88
D
D
.512
A factor of .512 euals an 156 rate of return. Kerification of the 156 rate of return"
Item
Amount of Present Value Cash 1*% of Cash Year(s) Flows Factor Flows 20-11
Chapter 20 Capital Budgeting Decisions
Investment in euipment.......................... 0ow ,<1'2+7)8= 1.888 Annual cash inflows................................ 1- ,+)88 .512 0et present value.................................... 2.
$actor of the internal D rate of return
,<1'2+7)8= 1'2+7)8 , 8
*euired investment Annual cash inflow
Fe 4now that the investment is ,1'2+7)8+ and we can determine the factor for an internal rate of return of 1'6 by loo4ing at the ,K table along the -period line. !his factor is '.255. >sing these figures in the formula+ we get" ,1'2+7)8 Annual cash inflow
D
'.255
!herefore+ the annual cash inflow would have to be" ,1'2+7)8 B '.255 D ,+. . a. )-year life for the euipment" !he factor for the internal rate of return would still be .512 Oas computed in <1= aboveP. *eading along the )-period line of the ,K table+ a factor of .512 is closest to .71+ the factor for 186. !hus+ to the nearest whole percent+ the internal rate of return is 186.
b. 7-year life for the euipment" !he factor of the internal rate of return would again be .512. $rom the ,K table+ reading along the 7-period line+ a factor of .512 is closest to .5/+ the factor for 226. !hus+ to the nearest whole percent+ the internal rate of return is 226. !he 186 return in part
20-12
Capital Budgeting Decisions Chapter 20
As this illustration shows+ a 'ecrease in years has a much greater impact on the rate of return than an increase in years. !his is because of the time value of moneyG added cash inflows far into the future do little to enhance the rate of return+ but loss of cash inflows in the near term can do much to reduce it. !herefore+ 9r. :lue should be er+ concerned about any potential decrease in the life of the euipment+ while at the same time reali(ing that any increase in the life of the euipment will do little to enhance her rate of return. '. a. !he expected annual cash inflow would be" ,+)88 x 1286 D ,')+888 ,1'2+7)8 ,')+888
D
.1
*eading along the -period line of the ,K table+ a factor of .1 is closest to .1/1+ the factor for 2)6+ and is between that factor and the factor for 2'6. !hus+ to the nearest whole percent+ the internal rate of return is 2)6.
b. !he expected annual cash inflow would be" ,+)88 x 586 D ,8+888 ,1'2+7)8 ,8+888
D
'./)
*eading along the -period line of the ,K table+ a factor of './) is closest to '.12+ the factor for 116. !hus+ to the nearest whole percent+ the internal rate of return is 116. >nli4e changes in time+ increases and decreases in cash flows at a given point in time have basically the same impact on the rate of return+ as shown below"
20-1
Chapter 20 Capital Budgeting Decisions
). Eince the cash flows are not even over the five-year period sing trial-and-error or more sophisticated methods+ it turns out that the actual internal rate of return will be 126" Amount of Cash 12% Flows Factor ,<1'2+7)8= 1.888 ,8+888 ./8) ,/1+) 8.)/
Present Value of Cash Flows ,<1'2+7)8= 185+1)8 '+588 , 8
Eales revenue............................................................. ess commissions <'86 ,288+888=........................ Contribution margin................................................... ess fixed expenses" Haintenance........................................................... ,)8+888 Insurance................................................................ 18+888 9epreciationJ......................................................... /+888 !otal fixed expenses................................................... 0et operating income.................................................
,288+888 58+888 128+888
Item Year(s) Investment in the euipment............................ 0ow Annual cash inflow........................................... 1-) Eale of the euipment....................................... ) 0et present value..............................................
&role
1. !he income statement would be"
7/+888 , 2'+888
J,158+888 B ) years D ,/+888 per year 2. !he initial investment in the simple rate of return calculations is net of the salvage value of the old euipment as shown below" Eimple rate of return
D
Annual incremental net operating income Initial investment
D
,2'+888 ,158+888 ,8+888 20-1)
D
,2'+888 ,1)8+888
D
1/6
Capital Budgeting Decisions Chapter 20
3es+ the games would be purchased. !he return exceeds the 1'6 threshold set by the company. . !he paybac4 period would be" ,aybac4 period
D
Investment reuired 0et annual cash inflow
,158+888 ,8+888 ,1)8+888 D D 2.) years ,/8+888J ,/8+888 J0et annual cash inflow D 0et operating income M 9epreciation D ,2'+888 M ,/+888 D ,/8+888. D
3es+ the games would be purchased. !he paybac4 period is less than the years. IK. Multiple Choice Questions 1. 2. . '. ). /. . 5. 7. 18.
9 C : : A C 9 : : A
11. 12. 1. 1'. 1). 1/. 1. 15. 17. 28.
9 9 9 C C 9 9 : A A
21. 22. 2. 2'. 2). 2/. 2. 25. 27. 8.
20-1+
C : C 9 C C 9 : 9 A
1. 2. . '. ). /. . 5. 7. '8.
9 C C 9 9 : : : 9 :
